Now that interest rates have risen, fixed-rate bonds and bank deposits are looking attractive again. But investors shouldn’t underestimate the potential impact of reinvestment risk further down the line.
Retails bonds and bank deposits are often seen as low risk investment options. After all, they offer a consistent and reliable income and you can be pretty sure of getting your money back at the end.
But that doesn’t mean that they don’t have any risk at all.
For one thing, bonds can still be volatile. Last year provided an exceptional example when the value of UK gilts tumbled following the mini budget in September.
Until rates started going up last year, having money in the bank would also have earned you hardly any interest. That means that, effectively, your money would have been losing value because of inflation.
But another risk that many investors don’t think about is known as reinvestment risk. And, often, it is something that catches them by surprise.
It’s all about the timing
This is because if you have money in fixed-rate bonds or bank deposits, that investment is always for a set amount of time. You might, for example, put your money in 36-month fixed deposit, which will guarantee you a certain interest rate over that period.
But what happens when that time is up? The chances are that the interest rate you will be able to earn if you put the money back in the bank will have changed three years down the line.
This is what is meant by reinvestment risk – that you might not be able to reinvest your money at the same rate at which you originally did when it matures.
Right now, with fixed-rate bonds and bank deposits paying much better rates than they have been for some time, this is worth thinking about. It may seem attractive to earn those rates today, but will they still be available when that investment matures and you need to invest the money again?
Why does it matter?
This might all seem a bit theoretical, but it does have real implications. If you are using the interest from a retail bond or bank deposit to pay for your expenses, you need to be able to keep earning that level of income if you want to maintain your lifestyle.
And this difference can sometimes be substantial.
In April 1990, for example, a five-year UK government gilt would have paid a yield of 13.5%. But when that bond matured in April 1995, five-year gilts could only be bought at yields of 8.3%.
For an investment of £100 000, that would represent a change in income from £1 125 per month, to £691 per month. In other words, a drop of 39%.
That sort of change would put a big hole in your monthly budget.
Managing the risk
Reinvestment risk is not, however, the same for all types of investments. If you are using a 12-month fixed deposit, for instance, that means that you are having to reinvest your cash every year, and you will be getting a different interest rate every time.
But if you buy a 10-year bond, your rate is set for that whole period. That gives you more certainty.
However, that also comes with risk of its own. Because if your money is locked up for 10 years, you have won’t be able to access it if your life circumstances change dramatically in that time.
It’s also possible to manage this risk by matching the date that the investment will mature with your time horizon. If you know that you will need the money in five-years’ time for something else, such as buying a retirement product, then you can match that with the term of your investment.
Building a ladder
A more sophisticated approach is to ‘ladder’ investments so that they mature over a number of years into the future. That way you will smooth out some of the changes in interest rates.
However, market cycles can be long, and it could still be possible that all of your investments mature over a period when rates are lower. This could potentially compound the risk, rather than lower it.
Putting your money into a money market or bond fund would achieve something similar, as this is one of the key strategies that fund managers will employ. They will try to invest in a range of different assets maturing at different times so that they can earn a more consistent interest rate.
Even so, the yields on these funds can vary materially over time.
Diversification
As with just about any investment approach, however, the best strategy is to diversify. Even if the risks in fixed-rate bonds and bank deposits seem lower than in the stock market, it’s worthwhile remembering that every investment comes with some type of risk. And being exposed to different risks is your best chance of mitigating them.
Dividend-paying stocks are an excellent alternative source of income. And, over the long term, they have the additional benefit that they will likely gain in value.
You also don’t need to worry about reinvestment risk, because you can hold the shares for as long as you like.
ALSO IN THIS SERIES
Concentration risk: what it is and how to avoid it
Volatility and risk are not the same thing
Horizon risk: what is it, and how can it be mitigated?
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